Protecting Business Assets Through Buy-Sell Planning

In our last few blogs, we have discussed issues that arise following the death of a spouse. A significant concern for surviving spouses during this time is the impact of the death on the operation of a family business, especially when that business is a primary source of income.  This can be an especially thorny problem for the surviving spouse if they were not active in the operation of the business, because they may then be at the mercy of key employees, business partners, or even family members whose interests are very different from their own. The possibility of a surviving spouse facing this situation is the best reason for a business owner to consider Buy-Sell planning. 

    

     Business interests are frequently one of a client’s most valuable assets, so it is important to consider how to handle such assets following the client’s death. A direct transfer of the business interest to a surviving spouse or children, according to the provisions of a client's Will or Living Trust, has the potential to cripple the operation of the business and significantly reduce its value especially if the surviving spouse or children have not been active in the business. Lack of operational experience, conflicts with staff and business partners, or lack of interest in running a business can all reduce the business’ value quickly or even cause the business to collapse completely, rendering it valueless. This is where a well-drafted Buy-Sell Agreement can assist in making a smooth transition following the client’s death 

     The purpose of a Buy-Sell Agreement is to establish how business interests transfer following the death of a business owner. Buy-Sell Agreements can be made between co-owners, between parents and children, and even between a business owner and their key employees. Typically, a Buy-Sell Agreement provides that one of the parties has the right or obligation to purchase the interest of the other party for whom a “triggering” event occurred. The agreement also defines what constitutes a “triggering” event, including death, disability, desire to sell, or retirement, to eliminate questions about when a party’s obligation arises. Additionally the Agreement provides a method for determining the value of the business interest and the terms for the payment of the sale price over a time span fair to all the parties. This ensures that following a death, the people active in the operation of the business know what will happen, allowing them to continue operations uninterrupted, and maintain the value of the company. 

     Often the parties to the Buy-Sell Agreement purchase insurance on the life of the business owners in order to provide funds for the purchase of that owner’s interest at their death. This is especially useful when there are non-family co-owners who may be put in an untenable business situation if the family members have no interest or knowledge in running the business, or want cash now and are unrealistic about the real value of the business. Life insurance proceeds can also be used to ensure that surviving spouses, or other children, receive fair value for the business when only some of the client’s children are active in operations. This allows the active-children to continue running things, without worrying about their surviving parent’s welfare or non-active siblings creating problems with the operation of the business. 

     A well drafted Buy-Sell Agreement takes into account the myriad of unexpected circumstances that may arise following the death of a business owner and attempts to foster a situation where that death has a minimal impact on operations. This allows survivors to either continue operating the business as usual or easily transition of ownership of the business, for a fair price, to those people the client chose as the next owners. 

     As always, it is important to remember that engaging in business planning should not be done without having good advice. A Buy-Sell Agreement is a binding legal contract and thus it is important to discuss Buy-Sell planning with an experienced attorney who can explain the substantial operational, tax, and planning impacts that the Agreement imposes on a client’s business.

The Unexpected Results of Probate Distributions

Last week’s blog discussed the process of probating an estate. This week we will continue that theme and discuss the distribution of an estate when the decedent has and has not left a Will. Later this week we will continue discussing estate administration with a look at the benefits of establishing a buy sell agreement for clients with interests in small (and not so small) businesses.

     As we previously discussed, the probate process can be both lengthy and expensive, but eventually the appointed personal representative is able to make distributions from the estate to the designated beneficiaries. If the decedent left a Will, those beneficiaries are the people named in the Will. If the decedent died without a Will, then state law dictates the distribution of the estate.

     After giving effect to the statutory allowances that we discussed in last week's blog, the personal representative first makes distributions to the decedent's surviving spouse. The size of the share distributed to the surviving spouse depends on the decedent’s other surviving relatives. The spouse is entitled to:

• The entire intestate estate if no descendant (child or grandchild) or parent of the decedent survives the decedent.
• The first $150,000.00, plus 1/2 of any balance of the intestate estate, if all of the decedent's surviving descendants are also descendants of the surviving spouse and there is no other descendant of the surviving spouse who survives the decedent.
• The first $150,000.00, plus 3/4 of any balance of the intestate estate, if no descendant of the decedent survives the decedent, but a parent of the decedent survives the decedent.
• The first $150,000.00, plus 1/2 of any balance of the intestate estate, if all of the decedent's surviving descendants are also descendants of the surviving spouse and the surviving spouse has 1 or more surviving descendants who are not descendants of the decedent.
• The first $150,000.00, plus 1/2 of any balance of the intestate estate, if 1 or more, but not all, of the decedent's surviving descendants are not descendants of the surviving spouse.
• The first $100,000.00, plus 1/2 of any balance of the intestate estate, if none of the decedent's surviving descendants are descendants of the surviving spouse.

For individuals with estates under $150,000.00, the law provides the surviving spouse is entitled to all of the assets. However, for larger estates, the intestate distribution statutes may result in distributions, to parents or children, which the decedent would not have intended.

     Speaking of unintended distributions to children, it is important to note that if an asset in the probate process passes to a minor child, that asset must be held in trust until the minor child reaches age 18, at which point the child, whether mature enough or not, receives the remainder of that asset outright and free of trust. In addition to the potential problem of providing a lump sum of money to an 18-year-old, the probate court requires that the personal representative provide an annual accounting of those assets to the court until the child turns 18. As with every other aspect of the probate process filing these accountings takes more of the personal representative’s time and has a financial cost.

     Clearly, there are potential problems that arise when a decedent does not have a Will. Some of these, such as unintended distributions to parents or children as opposed to the surviving spouse, and large distributions to children upon reaching age 18, may be avoided by executing a. However, other problems such as the financial costs and reporting burdens exist as long as the Probate Court remains involved in the administration of an estate.

     As we have advocated in our writings on this blog and in our practice, clients can avoid almost all of these issues through proper planning and the use of a Living Trust. The Living Trust ensures that the decedent’s decisions govern the distribution of their assets and does not rely on a one size fits all approach that can result in unanticipated consequences. Additionally, because a Living Trust is a private agreement there is no involvement of the probate court, which can expose the decedent's assets and distribution decisions to public scrutiny. Furthermore, the Trust's private nature allows for greater ease in making distributions following death and avoids the costs associated with long-term administration of an estate through the Probate Court if the client desires to hold assets in trust until such time as their beneficiaries can handle those assets responsibly.

     Keep in mind that each individual's needs are different and estate planning should not become a one size fits all commodity. It is important for clients to meet with experienced experts in planning fields and discuss their desires regarding assets after their death so that the client can receive advice best suited to their particular situation.

Introduction to Probating an Estate

As we discussed last week, the death of a loved one can be very trying. In addition to the emotional weight of the loss, survivors must also contend with the burdens of administering the decedent’s estate. 

     The first step in administering the estate is determining whether there are any assets that must pass through the Probate process. Under Michigan Law, any assets owned by the decedent alone, as well as IRAs and life insurance policies without valid beneficiary designations, must go through the probate process before passing to their new owners. The probate process can be lengthy and is very public. The probate is opened in the county in which the decedent resided at the time of death and a personal representative is named to administer the estate. Unless the decedent executed a Will naming a person to act as personal representative, the Probate Court will appoint someone to that role. Upon appointment, the personal representative receives "letters of authority" which gives them the power to act on behalf of the estate. 

     The personal representative is charged with gathering all of the assets of the estate and protecting them, which includes covering assets with insurance where appropriate, maintaining assets such as real estate, and protecting any other valuables. The personal representative must value the assets in order to file an inventory and regular accountings with the probate court, showing what is being done.

     The personal representative also has a duty to notify all actual creditors and potential creditors of the estate. Once notice is given, the creditors have four months to file a claim against the estate. The personal representative must then determine which claims are valid and then pay those claims, as well as any expenses or obligations of the administration of the estate. 

     The personal representative must also determine the beneficiaries of the estate, either by looking at the terms of the Will or, if there is no will, the state intestacy statute. The beneficiaries must be given information regarding the assets of the estate and their entitlement.

     The Michigan the Estates and Protected Individuals Code ("EPIC") provides for three allowances for either a surviving spouse or surviving children. These allowances take priority over other claims against the estate, except for administration costs and expenses and reasonable funeral and burial expenses:

• Homestead Allowance: The surviving spouse or surviving children are entitled to a Homestead allowance of $15,000, adjusted for inflation. This allowance ensures that surviving family has sufficient funds to pay housing and utility costs. This allowance has priority over all successive allowances.
• Family Allowance: During the period of probate administration, the surviving spouse and any minor children whom the decedent supported are also eligible for a reasonable family allowance to cover the cost of normal living expenses. While this allowance lacks a definitive value, the allowance is limited to a single year when it is clear that an estate is inadequate to discharge all other allowable claims.
• Exempt Property: The surviving spouse is also entitled to household furniture, automobiles, furnishings, appliances, and personal effects from the estate up to a value not to exceed $10,000.

     After completing all of these steps the personal representative can then begin to distribute the remainder of the estate to the heirs. On Thursday we will discuss the factors that impact the portion of an estate each heir receives. 

Working Together to Assist Clients

Today’s blog begins a series focused how attorneys and financial planners can work together to assist clients following the death of a loved one. Over the coming month we will address a variety of areas where clients benefit when their advisors work together as a team to make a very difficult time in their lives a little easier. We invite and encourage our readers to send us their thoughts on these issues so that we can take them into account as we tackle this complex subject.

     The loss of a loved one is one of the most emotionally difficult experiences a person will ever face. Sadly, during our careers as planners and advisors, we face the loss of a client, with unfortunate regularity. When those clients leave behind a surviving spouse or children, it is important to be prepared to assist those survivors while being mindful of their grief over their own loss. This is a perfect opportunity for the attorney and the financial planner to work together for the maximum benefit of their client.

     There are a wide variety of issues that arise after a death, including the administration of the decedent’s estate and trust, updating estate planning documents for surviving spouses, and making financial decisions that take into account their changed circumstances. Some of these decisions must take priority over others and it falls to attorney and planners, who handle these matters with more regularity, to keep clients from becoming overwhelmed by the decisions that must be made, even as the client still grieves for their loved one. 

     Immediately following a death it is important to quickly determine if there are any documents showing the deceased client wished to make anatomical gifts, had a prepaid funeral, or left specific instructions for funeral or memorial services, as well as a specific burial request. This is important first because such instructions elevate the need for survivors to make certain decision, but also because discovering these instructions after the survivors take other contrary actions can be devastating. 

     After addressing matters related to the disposition of the decedent’s remains, the personal feelings of the client are paramount and their mourning should take precedence over meetings with planners and advisors, but when they are able, it is important to begin the process of administering the estate and trust. A first step in the process is to determine a list of assets and values held in the estate of, or a living trust of, the deceased spouse. The client's planner often as this information and is the best person to assist in developing a list of assets. Documents should be reviewed to determine ownership of assets and beneficiaries of any insurance policies or IRAs. A review of estate planning documents will indicate whom beneficiaries are, what are the terms of distribution, and who are the persons chosen to help administer the estate, the personal representative and the successor Trustee.

     In this stage of the process, the attorney can assist the client in determining whether any probate of assets is necessary and whether it is necessary to file a federal estate tax return. If a business was part of the deceased's estate, it is important that the surviving spouse and successor Trustee continue to handle the management of that business appropriately. It is also important to determine if any Buy-Sell Agreements exist to govern the transfer of the business to surviving partners. Finally, if there are any assets outside of the state of Michigan these will also have to be administered. 

     With their more complete knowledge of the assets, the planner is invaluable at this point in the process for determining what assets remain available for the spouse, revising  the surviving spouse’s investment plan and providing a strategy for cash flow for both the short-term and long-term to assist the client in maintaining his or her lifestyle.

     This only begins to scratch the surface of the choices that face clients at this difficult time in their lives. Over the coming weeks we will address a variety of issues in greater detail, paying special attention to how attorneys and financial planners can work together to assist clients in managing these issues. As we continue to explore this topic we must remind ourselves that as important as this planning is to our clients, we must always balance the need to make decisions with the client’s need to mourn their loved ones.

Federal Estate Tax: Onerous & Unfair or Much Ado About Nothing?

     A common worry for nearly every adult is the impact of taxes on their lives. This is especially true for estate planning, where clients worry about the taxes their beneficiaries will be liable for at their death. The good news for all of these clients is that their beneficiaries generally are not liable for any amount of taxes on their inheritance, because the tax liability is the primary responsibility of the estate prior to distributions, and not the beneficiary. In addition, clients are relieved to learn that because of the most recent estate tax changes, they are unlikely to have any estate tax liability at all. 

     The estate tax, is a tax on the transfer of assets from one person to another at death. People tend to understand the requirement of paying income taxes or sales tax, but feel differently about the estate tax because of the perception that taxes already been paid on the assets to be transferred at death and should not be taxed again with the estate tax. While this is a common belief today, estate taxes have existed in various forms around the world for hundreds of years. Only recently has the perception that such transactions are different from other exchanges gained popularity. 

     A reason for this change of perception can be traced back to as early as the 1940s when opponents of the tax began to refer to it as a "death tax," but the most recent push against the tax began during the late 1990s when Newt Gingrich served as Speaker of the House. Since that time, rarely has a federal legislative session passed without someone proposing a complete repeal of the estate tax. In the current Congress, Senator John Thune recently proposed such a repeal. Like many others who attempt to raise the population’s ire towards the estate tax, Sen. Thune takes liberties with the facts about the law. In his most recent statements on the proposed legislation, Sen. Thune attempted to garner support from small business owners and farmers by stating that one-third of businesses who owe estate tax will owe more in taxes than the assets of the business. Unfortunately for Sen. Thune is incorrect, based on the law as it stands today. The Senator’s office later confirmed that Sen. Thune was quoting from a more than decade old report from a time when the estate tax exemption threshold was $675,000, and also omitted the fact that the statistics he cited only referred to liquid assets of the business and not the total value of the business. These sorts of distortions are precisely the reason that a tax that affects so few people presents such a common concern for clients.

     The truth is that the estate tax has almost no impact on the vast majority of people. This is because there are two major exemptions to the estate tax that result in almost no one paying any tax. The first major exemption is the Marital Exemption, which allows the spouse of a deceased individual to inherit any amount of money without paying any estate tax. This means that no matter how large an estate may be, if it passes to the decedent’s spouse there will be no tax liability. With the Supreme Court's 2014 Windsor decision, this exemption applies to both legally married opposite sex and same-sex couples.

     The second major exemption, known simply as the Estate Tax Exemption, creates a threshold under which an estate will not have any tax liability. Currently that threshold is $5,430,000 for a single individual and the decedents surviving spouse may roll over any unused portion of the exemption at their death. This means that a married couple must have an estate larger than $11,860,000 before they will pay even one dollar of estate tax. As a matter of fact, in 2013, 2.6 million people died in this country and only 4,700 of them had to pay any estate taxes, less than .2%. 

     A benefit of this very high threshold for taxation is once clients understand that their estate is not subject to the estate tax it frees them up to focus on what is really important in estate planning--. designing a plan to distribute their assets to their loved ones in a manner that is in the beneficiaries' best interests without requiring any complex legal maneuvering to mitigate taxes.